A Premature Eulogy for Public Companies?

On its face, the number is stark: From the end of 1997 through this August, the number of companies listed on stock exchanges in the United States plunged by 44%. Some observers say this trend heralds the “twilight” of the public corporation, as companies try to avoid the expense and hassle of answering to shareholders and instead look elsewhere for capital — to sources like the private equity industry.

But other experts say “no,” insisting that the drop in listed firms is offset by other factors or due to temporary conditions. And they argue that going public is still the best way for many firms to raise capital — and will continue to be. “The idea that public companies will die, that’s actually somewhat old news,” says Wharton finance professor Alex Edmans. “The demise of public companies has been predicted many times in the past…. But it hasn’t transpired. There are many benefits to the public corporation.”

So who is right? Are public companies fading or not? Or is it too soon to tell? And if the best and brightest companies do shun the stock market, what will the result be?

The latest public-markets-are-fading salvo came in a blog post in The New York Times by Nancy Folbre, an economics professor at the University of Massachusetts, Amherst. “Public corporations that ordinary people can invest in and get rich from represent one of the great selling points of American capitalism — at least according to the salesmen,” she wrote early in September. “Yet corporations, which rose to dominance in the United States economy in the second half of the 20th century, are now waning in significance.”

This kind of argument arises from time to time, yet public corporations survive, says David A. Skeel, a professor at the University of Pennsylvania Law School. “It does have the feel of one of those bold statements that’s really great for headlines but is implausible once you scratch around the surface a little bit,” Skeel notes.

While the private equity industry has grown, it is not likely to take the place of the public markets in providing capital to companies, adds Wharton finance professor Richard J. Herring, noting that PE firms generally invest in “portfolio companies” for only a few years before selling them — often to stock investors in initial public offerings. “Several major firms have been purchased by private equity firms,” he says, “but generally they will be restructured and return to the public market. That is usually the favored exit option.”

‘Triumph of the Shareholders’

[From 2009, American SE figures are included in NYSE Euronext US data. Source: World Federation of Exchanges.]

In the Times piece, Folbre drew from a recent paper by Gerald F. Davis, a professor at the University of Michigan’s Ross School of Business. Titled, “The Twilight of the Berle and Means Corporation,” it referred to the fading of the type of dominant public corporation described in 1932 by Adolf A. Berle, Jr., and Gardiner C. Means. Berle, a Columbia Law School professor, and Means, a Harvard economist, foresaw “an economy dominated by a handful of ever-larger corporations run by an unaccountable managerial class,” Davis wrote. In their view, as the number of shareholders increased, and as shares passed from one person to another in the secondary market, these owners would gradually lose control of managers who were out for themselves, and the system would eventually become a kind of feudalism.

For much of the 20th century, public corporations did indeed become larger and more powerful, leading to the mega-corporations, or conglomerates, formed by mergers in the 1960s, according to Davis. “ITT grew from 132,000 employees in 1960 to 392,000 in 1970, adding Sheraton Hotels, Hartford Insurance, Continental Banking, Avis Rent-a-Car and dozens of other businesses to its portfolio,” he wrote. “During the same period, GM added 100,000 workers and AT&T added almost 200,000…. Berle’s and Means’s prophecy about the ever-increasing concentration of corporate control seemed to have come true.”

But he said the landscape changed during the Reagan Administration, when the Justice Department eased rules that had restricted mergers within the same industry, the Supreme Court struck down state laws limiting hostile takeovers and the IRS opened the door to 401(k) retirement plans in the workplace. That encouraged millions of Americans to own stock in mutual funds — and gave Wall Street more power over Main Street, Davis noted. “The proportion of households with money invested in the market increased from just over 20% in 1983 to more than 50% by 2001,” he wrote.

All these changes led to a growing emphasis among managers, shareholders and other players on public firms’ role in maximizing value to shareholders. Managers have come under increasing pressure to raise stock prices or be replaced. In his paper, Davis termed it the “triumph of the shareholders.”

Shareholders, rather than losing power as Berle and Means had predicted, gained it, as more and more shares ended up in the hands of institutional owners like mutual funds, insurance companies, pension funds, hedge funds and private equity funds. Assets in 401(k)s, which mainly invest in mutual funds, soared from $135 billion in 1980 to $12 trillion in 2007. A handful of mutual fund companies became the largest single shareholders in many major corporations, Davis reported.

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Though the number of public corporations continued to grow well into the 1990s, the “shareholder value movement” gradually led more and more managers and other insiders to feel that being public was more trouble than it was worth, Davis wrote. For public companies, regulatory scrutiny is tighter than for private ones, and the need to meet shareholders’ constant demand for stock-price gains made long-term strategies more difficult.

Then, new techniques like leveraged buyouts allowed managers to get out from under shareholders’ thumbs by taking public companies private. Other companies never went public in the first place. Companies that needed capital to grow found they could turn to alternative sources like the private equity industry, rather than sell shares to the public, Davis argued.

In the three major U.S. stock exchanges — NYSE Euronext, NASDAQ and the American Exchange (acquired by the NYSE in 2009) — listed companies peaked at 8,823 in 1997 before beginning a steady decline to 4,957 at the end of August, according to the World Federation of Exchanges. Not only are there fewer public companies, they tend to be different. “In recent years, corporations have become less numerous, less integrated, less concentrated and more ephemeral, and more constrained by their shareholders,” Davis concluded.

He observed, ominously, that the decline in public companies coincides with the worst stock market performance in U.S. history, during the first decade of the 21st century. Many of today’s corporations, he added, have adopted practices exemplified by Nike and Apple, which are based in the U.S. but have most of their employees overseas, causing a drop in U.S. employment by the largest firms.

A Change on the Margin?

But is the change really that dramatic? Are public corporations now passé? Or are their declining numbers just a somewhat wider-than-normal swing of the pendulum?

Edmans thinks too much is being made of the listings decline, which he characterizes as changes “on the margin.” The rise in regulatory costs in recent years, he says, is like a rise in room rates at hotels. Certainly, that would discourage some potential guests, but the hotel will still be there, serving many others.

Christopher C. Geczy, an adjunct finance professor at Wharton, says the decline in listings has been offset by growing market capitalization — share price times shares outstanding — among the firms that remain. And while Davis noted a large drop in the number of people employed by the 25 largest public firms, Geczy states that employment by publicly owned firms does not appear in trouble if one takes a larger sample.

Part of the decline in listings is due to a drop in the number of initial public offerings, which traditionally help replenish the list as other companies merge, go private or go under. In 1996, there were 561 IPOs; in 2008, just 28. The financial crisis and faltering stock market have been key factors, as companies don’t want to sell shares when prices are low.

In addition, the extremely low interest rates of recent years have made it preferable for many firms to raise money by borrowing rather than issuing shares. And a number of firms once listed in the U.S. have switched to stock exchanges in London and elsewhere. While that is a worry for U.S. exchanges, it’s not a sign those companies are abandoning public ownership.

Premature obituaries have been written for public companies before, Skeel points out. Among the most notable was a 1989 Harvard Business Review article, “Eclipse of the Public Corporation,” by economist Michael C. Jensen, who made many of the same arguments as Davis. Despite Jensen’s analysis, the number of listed companies in the U.S. continued to rise for eight more years.

Many firms that have been taken private, have delayed going public or decided to never go public, are on the “borderline” — not quite big enough to easily handle the regulatory costs and shareholder hassles public firms must contend with, Skeel says. The costs of dealing with regulation did indeed rise with the passage of the 2002 Sarbanes-Oxley Act, in the wake of the Enron and WorldCom scandals, he notes.

“Certainly, the push for corporate governance [accountability] since Sarbanes-Oxley is a factor that causes some firms to stay away from the public markets,” adds Wharton finance professor Itay Goldstein. “You need to comply with all these corporate governance requirements. Everyone is looking at your stock price. Shareholder activists are breathing down the back of your neck.”

He points to Facebook, which stayed private for years after many experts felt it was time to go public. Staying private gave Facebook more freedom to do as it liked in a fast-changing market. “But to say that this is going to end up with public markets being less important, I just don’t buy that,” Goldstein adds.

The Perks of Going Public

Academic research has shown that in recent years, young firms have tended to wait longer to go public than in the past, Geczy says. But many firms, including Facebook, do go public eventually. Facebook had no other way to raise the funds it needed to continue growing, and the public markets do offer benefits that alternatives like private equity cannot match, Geczy points out.

Federal rules, for example, prohibit most small investors and mutual funds from investing in PE firms. Many investors that can put money into PE don’t do so because of fund rules that typically bar withdrawing money for a decade or more. “So, when you finance yourself with private equity, investors cannot sell their stake very easily,” Goldstein says.

Many people and institutions with cash to invest are put off by this illiquidity, meaning that PE firms cannot match the capital-raising power of the public markets. PE funds are also very opaque, and many investors prefer the transparency offered by public corporations that have extensive disclosure requirements, Goldstein notes. While executives at public companies do chafe at the rules, even they benefit from them, Goldstein adds, because the markets provide lots of feedback to guide management. “I think one of the key advantages of public markets is that they gather information from many different people in the economy, and this can provide key information for decision makers,” he says.

“Sometimes, the managers can learn from the stock price,” Edmans adds. The shares’ rise and fall, for instance, can provide insight into whether the firm should invest in growth or hunker down.

Some experts also question whether shareholder activism is the crushing burden Davis and others claim it is. While hedge funds and some big pension funds have stepped up pressure on companies they invest in, the mutual fund industry has not followed suit, Skeel says. Passively managed funds — index-style mutual funds and exchange-traded funds — simply buy and hold shares of firms in the indexes they track, and do not typically use their voting power to pressure management, Skeel notes. In fact, the funds cannot even vote with their feet, as they must own the stocks in their benchmark index. Actively managed funds, though they do try to pick winners, are less likely to pressure management than to simply sell their holdings if they think a company is poorly run or underperforming.

For funds, which now compete by offering ever-lower fees, “one way to keep your costs down is not to engage in proxy fights,” Skeel says.

Another benefit of public ownership: A firm has more owners than if it were private. While a private equity firm may own a controlling stake in a company in which it has invested, this is not common with public companies. Hence, public ownership can muffle the cries of a minority of unhappy shareholders, making life easier for managers rather than harder. “These other [forms of ownership] don’t offer the dispersal [of ownership] you get” as a public firm, says Wharton finance professor Jessica Wachter.

Is there, then, nothing to worry about as the number of listed companies’ declines?

Wachter says that a decline in public corporations could produce unwelcome results. If the list of public corporations becomes less diversified as a result of being smaller, stock returns could become more volatile, she points out. “We don’t know for sure if it’s happening, or what the effect will be, but it’s possible that the result could be negative,” she adds. That could be harmful to investors, including those millions with retirement money in 401(k)s.

On the other hand, the decline in public-company listings may be just a passing phase — a “trend” that could reverse if Washington eases regulatory burdens, the economy picks up and the financial markets return to normal. It could be years before the verdict is in.